RPT-Fed's solo act gets tougher with ECB, others in stimulus mode

Reuters Staff

7 Min Read

(Repeats item published on Jan. 22 with no changes to text)

By Howard Schneider and Michael Flaherty

WASHINGTON, Jan 22 (Reuters) - Federal Reserve policymakers, already struggling to assure investors that they remain on track for a mid-year interest rate rise, will find the task has just become harder with their peers in Europe and elsewhere headed in the opposite direction.

The swelling ranks of central banks cutting rates and ramping up stimulus make it more difficult and riskier for the Fed to proceed with plans to end crisis-era policies, according to Fed analysts and former staffers.

It is not unusual for central banks to be out of synch at times, but the deepening divide between the Fed and much of the rest of the world is unprecedented, heightening the risks and uncertainty surrounding the Fed's plans, economists say.

The European Central Bank's decision on Thursday to pump 60 billion euros ($68.17 billion) a month into the faltering euro zone economy just deepened the divide. The stimulus rivals the size of the quantitative easing program the Fed ended only three months ago in a sign of confidence about U.S. economic recovery.

The euro fell below $1.14 after the ECB announcement, its lowest level since July 2003, while interest rates on long term U.S. bonds continued their recent nosedive.

"The foreign outlook...has darkened. And that will make this decision - lift off, the path of interest rates thereafter, how you communicate it - harder," said Jon Faust, director of the Center for Financial Economics at Johns Hopkins University in Baltimore and a former adviser to Fed chair Janet Yellen.

"It will be doubly important for the (Fed's policy setting committee) to communicate how it is thinking about risks flowing from abroad, because we are facing a truly unique constellation of circumstances."

The Federal Open Market Committee meets next week, and is expected to repeat that those risks from abroad have yet to throw the U.S. recovery or their rate plans off track. U.S. central bankers have been adamant on that point over the past several months despite tumbling oil prices, ebbing global growth, and market expectations that the Fed will eventually capitulate and delay its first rate increase since 2006.

U.S. policymakers have insisted that as long as the economy continues generating jobs, growth will remain on track and inflation eventually would begin to rise towards the Fed's two percent target.

PULLING THE OTHER WAY

But next week will test whether, in fact, they are willing to swim against the current in conditions that get tougher by the week, and also if they can make their case convincingly.

The ECB is not the only one pulling in the other direction.

The Bank of Japan and a host of important secondary players - Canada, India, Turkey, China, Denmark, and Switzerland among them - have cut interest rates recently, often surprising markets and showing how unpredictable conditions have become.

The steps those banks are taking will make the mechanics of raising U.S. rates more challenging: lower rates and massive new liquidity overseas will lure investors to U.S. assets as the higher-yielding safe haven of choice, pushing down the very rates the Fed will try to increase, and driving up the value of the dollar.

They could also hurt U.S. jobs and growth, the indicators the Fed arguably cares most about. Fed officials have downplayed the dollar's strength, noting that the United States is less reliant on trade than other developed nations, and able to count more on domestic demand.

Yet the impact could be significant.

Bank of Canada's surprise rate cut on Wednesday knocked down the Canadian dollar against the U.S. currency below 81 cents, adding to a drop of 15 percent since mid-2014. Canada is the United State's largest trading partner. It also shares supply chains in the auto and other industries that allow jobs and investment to shift to the cheapest source.

Other countries may follow along soon, driving up the value of the dollar further and making U.S. goods more expensive.

"The pressure on other commodity-dependent central banks to follow suit will likely rise in the coming months as they wipe the dust off their competitive devaluation playbook," said TD Securities analyst Millan Mulraine.

OPENING THE FLOODGATES?

The Fed will also now have to contend with a potential flood of money from investors looking to the United States as the global economy's sole bright spot.

U.S. bond rates have been falling in recent months. Hundreds of billions of dollars that will be created by the ECB and potentially other banks in coming months may be headed this way, meaning even more downward pressure on market rates and dollar strengthening that the Fed will have to deal with when it decides to hike.

There are other risks as well.

If Europe, Japan, China and other economies fail to respond to more stimulus, it would reinforce the notion that the world has moved into a permanently lower gear, so called "secular stagnation" - a bad omen for U.S. wages and growth.

The World Bank also warned last week that developing countries "may be tested" in coming months if investors decide to shift from emerging market stocks, bonds and businesses into U.S. assets.

In the tidal struggle that is developing over the direction of global interest rates, investors last year already pulled a quarter of a trillion dollars out of emerging markets, according to a recent report by the Institute of International Finance. Cross-border investment is expected to fall again in 2015 as a Fed policy shift approaches, according to the IIF.

"We have not lived through a period of such wide monetary policy divergence...We don't have a good roadmap for how this plays out," said IIF chief economist Charles Collyns.

If Fed tightening proceeds, it could lead to market turmoil, potentially undermining global growth and, in the extreme, the U.S. recovery. "The markets could wake up one day and make a substantial and abrupt move and it could have quite a negative impact." ($1 = 0.8801 euros) (Additional reporting by Jonathan Spicer in New York and Ann Saphir in San Francisco; Editing by David Chance and Tomasz Janowski)